Welcome to the eleventh issue of Ideas and Institutions – a fortnightly newsletter from Carnegie India’s political economy team.

This issue includes an essay on fintech and the future of public sector banks in India, and a review of the book Law and the Economy in a Young Democracy by Tirthankar Roy and Arvind Swamy.

Fintech and the Future of Public Sector Banks

On July 7, Finance Minister Nirmala Sitharaman instructed all public sector banks to onboard the account aggregator platform. Once implemented, this would mean that the banking transaction information for the consumers of public sector banks would become available, subject to consent, to any other financial firm in the system. Even today, the accountholders are free to download and share their financial information, but this process is cumbersome and relatively easy to tamper with. Account aggregators can make this much more secure and convenient. Brought together in one place, based on the consumer’s consent, this information could become useful for underwriting loans and insurance policies. It can also make it convenient for consumers to manage their financial lives by giving them one place to access all their financial information.

While it is important to consider the long-term implications of account aggregator framework for the financial system and for the economy, in this essay, we focus on the potential impact on public sector banks, which will now make their financial information available, irrespective of their size and market share. Once these banks make this information available through the account aggregators, any financial information user in the system will be able to use the information to provide financial services to the consumers of these banks.

In a way, this can be seen as a loss of advantage. Public sector banks have built up transaction histories of their consumers, some of them going back several years. This information is valuable for understanding the consumers, something for which they incurred costs. While the consumers will be empowered, the public sector banks would lose some of the advantage that came from having this information. For each financial institution, it is a matter of judgement whether joining this system is in its interest. The institutions that use this access to financial information better than others would gain from this framework.

Two facts are worth considering while analyzing the potential impact on public sector banks—the background condition of poor growth in public sector banks’ credit book and the challenges that the public sector banks face in making the most of new technologies.

First, the government’s instruction to the public sector banks to onboard the account aggregator platform comes against the backdrop of several years of poor credit growth in these banks. Between 2014-15 and 2021-22, the total credit by public sector banks saw no growth at all in real terms. In spite of trillions of rupees of capital infusion in public sector banks, the growth rate in credit has been about the same as the inflation rate during this period. In the same period, the average growth in private sector banks’ total credit, net of inflation, was about 13.1 percent per year.

Because of a variety of reasons, public sector banks have not succeeded in growing their credit books. Now, when they will be forced to share the financial information with others, they will lose another source of advantage. Among the categories of loans given by public sector banks, only personal loans saw a significant increase in recent years. This is also the category in which loan underwriting can benefit a lot from intelligence generated by transactional data.

Second, as the advent of technology-driven banking has been changing the role of human resources in the field, the public sector banks have not been able to make the most of this shift. Functions earlier performed at branches are now performed at ATMs or are completely online. Functions earlier performed by human beings are now automated. With the growth in business, banks do hire more personnel, but the profiles of employees and their skillsets are different. As technology has started replacing humans for some of the functions, private sector banks have been quite agile in restructuring their human resource strategy. However, public sector banks have not enjoyed such flexibility and have been losing competitiveness in the process.

In 1999-2000, the share of clerks and subordinates in the total number of employees of public sector banks was 75 percent, and that for private sector banks was 72 percent (the other employees were categorized as officers). By 2019-20, the same, for public sector banks, had shrunk to 50 percent, but for private sector banks, they comprised only 6.5 percent. As anyone who has dealt with private banks knows, they hardly have any clerical or subordinate personnel on their rolls. So, even as they have deployed technology, the cost-saving advantage for public sector banks has not been as much as that for the private banks.

With the expected rise of fintech, the public sector banks will face even more challenges on both these fronts. They will find more competition in the credit business, with many of their competitors using the financial information of their consumers for underwriting loans and providing other financial services. Further, as the role of technology grows, the lack of flexibility in these banks might incapacitate them even more. While it is too early to predict the long-run impact of fintech on banks, there are scenarios in which banks may face significant disruption to their business. The Bank for International Settlement has presented plausible scenarios in which banks would either be relegated to playing second fiddles to fintech firms that would own the customer relationships, or be completely disintermediated as the functions previously performed by banks would be performed by fintech firms.

A key force in the actualization of these potentialities is the unbundling of banking. Payments have already been substantially unbundled, with independent fintech firms debiting and crediting bank accounts through the unified payment interface. Loans underwritten based on the banks’ financial information would progressively take the credit business away from banks. The disruptions may not happen suddenly, but as the experience of the last few years of negligible credit growth shows, over time, the public sector banks may lose ground.

In and of itself, the reduction in the role of public sector banks is not a cause for worry. But since they still hold more than 60 percent of the total deposits with scheduled commercial banks, the government needs a strategy for them.

So far, the government has deployed three strategies to improve the performance of public sector banks: recapitalization, reform, and restructuring. Since 2015, the union government has pumped in more than three trillion rupees to recapitalize public sector banks through budgetary allocation and recapitalization bonds. This capital was required to absorb losses arising from high levels of non-performing loans. The government has also tried to implement various reforms to improve the performance of public sector banks. This has been done through annual reform packages under the title of EASE (Enhanced Access and Service Excellence). The latest of these was announced in June this year. Certain governance and management reforms have also been implemented occasionally. Finally, government also restructured public sector banks by merging some of them. Based on an announcement in 2019, ten of the public sector banks were consolidated into four banks.

These strategies have yielded mixed results. Credit growth has not picked up, and public sector banks have continued to lose ground. The share of public sector banks in the total outstanding credit of scheduled commercial banks fell from 73.3 percent in March 2014 to 54.9 percent in March 2022. To be sure, the lack of credit growth in these years is not just about the competitiveness of these banks. A major reason was the clean-up that was necessary after years of aggressive lending. However, even after the clean-up of their balance sheets, credit growth has remained tepid.

The government should consider enhancing the set of strategies with respect to the public sector banks. A key missing strategy is resolution. Under the present legal framework, it is very difficult for the government to use resolution tools for failing public sector banks. The most common tool of resolution—merger with another bank through a competitive bidding process—is likely to face legal hurdles. A legal reform, which amends the bank nationalization laws and also creates a legal framework for the resolution of failing banks, is required to enable this option. Another strategy is to privatize some of the public sector banks to test the process, and then to implement the process for more and more public sector banks. In Budget 2021-22, the finance minister did announce the intention to privatize two of the banks, but no action has been taken yet.

The coexistence of public sector banks with the more agile private sector ones is challenging enough. Now with the advent of fintech and the unbundling of banking, the challenges are only likely to increase. Continuing with the strategies of recapitalization, reform and/or restructuring may not suffice. The government will need to develop a more comprehensive set of strategies to deal with banks that are not able to compete in the context of the rise of fintech.

—By Suyash Rai

Do Laws Hinder Economic Development? A Review of Law and the Economy in a Young Democracy

Are Indian laws binding constraints to India’s economic growth? One set of scholars and intellectuals has argued for the primacy of regulatory reform as key to unleashing India’s economic potential since 1991. Others, such as Dani Rodrik and Arvind Subramanian, have argued that India’s transition to high growth started in the 1980s, and was sparked by “. . . an attitudinal shift on the part of the national government towards a pro-business (as opposed to pro-liberalization) approach.

Tirthankar Roy and Anand V. Swamy, in their book Law and the Economy in a Young Democracy: India 1947 and Beyond (2021), argue that laws and rules in some sectors are indeed increasingly becoming binding constraints after 1991, with the growth of private markets and the necessity of enforcing private contracts. In a wide-ranging historical analysis of Indian laws on land, property, company law, environment, and labor, the authors analyze the patterns of continuity from colonial-era laws to present-day legislature in these sectors, the degree to which post-independence laws have met their proclaimed egalitarian objectives, why some laws have been easier to reform than others, and the influences of globalization on legal changes in sectors like intellectual property.

The starting point of their analysis is the heritage of colonial laws. Laws before independence were promulgated to do both, maintain the primacy of British economic interests, and maintain social—and therefore political—stability. This is most clearly visible in the structure of land rights and agricultural credit laws enacted during British rule. British revenue interests were protected by the land tenure systems codified by them, while social stability was sought to be protected by the legal recognition of tenancy rights and protection of tenants from eviction. Post-independence, laws focused on mitigating the inequality in land rights through redistribution and ceilings. To protect the new beneficiaries of these policies, laws also restricted land transferability.

Contrary to now-prevalent government thinking, the authors argue that some objectives of these post-independence laws were successful, even though their implementation was uneven. Millions of tenants became owners due to zamindari abolition and undocumented tenants received legal protection for the first time. However, they also point out that as the composition of economic activity has changed over the years, land is now increasingly required for manufacturing and urban growth. The laws that earlier sought to protect tenants by restricting transferability have now become constraints. The authors argue that even though policymakers recognize this issue, there is a “fear that the poor will be cheated in land market transactions.”

Regarding rural credit laws, the authors point out that the overriding interest of the British was to maintain social and political stability. The progenitor of rural credit laws that regulate private moneylending was the Deccan Agriculturalists’ Relief Act, 1879. The law was passed in the wake of a riot by Deccan peasants. Since then, the prevailing ideological motivation for regulating private moneylending in rural areas has been that of “lender malfeasance”. The authors point out that the state response to microcredit institutions in Andhra Pradesh in 2010 emerged from similar motivations.

Why do these ideological patterns persist? The authors argue that economic development in India is taking place in a thriving democracy. This requires continual political negotiation and renegotiation. The controversies over land acquisition for economic development exemplify this tension between the government’s wish to promote development through eminent domain powers and the vocal—and sometimes violent—protests against such acquisition.

In the field of labor law as well, one important motivation behind the structure of these laws was to have the government as the prime intermediary between labor and entrepreneur. This started with Congress’ understanding that political and governmental arbitration of labor disputes is essential to maintain stability. The authors point out that the early insertion of political parties and governments into industrial disputes eventually gave Indian labor unions an unusual character. In Western countries, skilled workers headed unions. In India, by contrast, they were headed by “white-collar politicos.” In addition, many large workplaces had multiple politically affiliated unions, in contrast to a single union in many Western countries. These features posed obstacles to collective bargaining. In contrast to land acquisition law, however, no serious reform of labor laws has taken place. Even as firms adjusted to economic necessities by using more contractual labor, there was a huge resistance to any reform.

There have, however, been serious and continual reforms in finance and company law since the 1990s. A new market regulator, SEBI, was created in 1992. The companies law was rewritten, as was the partnership law. Tribunals were created to provide specialized and timely dispute resolution services. Foreign exchange regulations were reformed. “After the reforms, the share of private investment began to move upward, exceeding 20% by 2015.” Globalization also exposed Indian family-run firms to global competition and acted as an impetus to corporate reorganization.

The authors, however, do not explain why it has been relatively easy to reform the financial sector than, say, land and labor. Policymakers seem to be aware of the need to reform but seem unable to overcome the constraints in the way of reforming these sectors. A partial explanation provided by them echoes Kelkar and Shah (2019). The authors speculate, “In enacting a body of law . . . on corporate governance, there isn’t a large body of potential losers from reform, and it will not cost the government too many votes. . . . However, if the law pertains to (say) the terms on which an industrialist can acquire farmers’ lands, this is now a potentially far more potent question."

The book provides fodder for additional inquiry. How do we understand the causality between legal reforms, political settlements, and economic development? While Hausmann, Pritchett, Rodrik (2005) find that economic reforms have a significant impact on sustained economic reform, Rodrik and Subramanian, and others such as Pritchett, Sen and Werker (2017), argue that long-run economic growth requires a political settlement in favor of creating and sustaining such growth. In this analysis, laws are an outcome of the political settlement, and not necessarily sufficient for economic growth. For example, if enforcement is weak, the legal regime may not be of material importance. The authors also describe this phenomenon in their explanation of the informal market for land tenancy.

More specifically for India, if laws are binding constraints to economic growth, why has the share of private investment declined steadily in the last decade after the steady increase described by the authors, even though the legal framework in finance has remained the same? It could be that the constraints are upstream from the legal system, in the realm of politics.

—By Anirudh Burman